A behavioral perspective to causes of global imbalances

David Laibson and Johanna Mollerstrom provide an alternative explanation to the reason for surge in global imbalances. The paper is here. (It is a NBER version. The free version is not yet available).

Bernanke (2005) hypothesized that a “global savings glut” was causing large trade imbalances. However, we show that the global savings rates did not show a robust upward trend during the relevant period. Moreover, if there had been a global savings glut there should have been a large investment boom in the countries that imported capital. Instead, those countries experienced consumption booms. National asset bubbles explain the international imbalances. The bubbles raised consumption, resulting in large trade deficits. In a sample of 18 OECD countries plus China, movements in home prices alone explain half of the variation in trade deficits.

Another validation to the idea where excess liquidity in past went. Not for any productive investments but for consumption and building assets. Alan Taylor et al has shown similar results for a much longer time series. Turner has questioned the basic idea of more liquidity and suggests there is diminishing return after a point.

Back to the paper. More details:

In the current paper, we argue that the theory of a global savings glut does not explain the observed data. To make this point, we provide several arguments. First, we show that the global savings and investment rates did not show a robust upward trend during the period that Bernanke associated with the global savings glut, 1996-2006.3 Had a global savings glut existed (an outward shift in the world supply of savings) it should have caused a boom in global observed savings and investment.

Second, we calibrate a model for the economies that received capital inflows. The calibrated model predicts that if there had been a savings glut there should have been a large investment boom in the countries that imported capital. For our benchmark calibration, we .nd that the investment rate should have risen by at least 4% of GDP. Intuitively, if the Chinese government exogenously loaned U.S. households a trillion dollars, those U.S. households should have chosen to invest a substantial share of those funds to help make the interest payments. However, such an investment boom did not occur. Instead the US absorbed most of the imported capital through a consumption boom.

This calibration also casts a critical light on the arguments of Caballero, Farhi, and Gourinchas (2008a, b), hereafter CFG. Like Bernanke, CFG also hypothesise that an external shock led the U.S. to run international imbalances. Unlike Bernanke, they argue that this inflow derived from an asset- shortage in Asia. In their account, Asian savers sought new markets in which to invest their wealth. However, the exogenous capital flow hypothesised by CFG should have led to a counter-factual investment boom in the economies that absorbed those flows.

The findings:

We suggest an alternative explanation for the unbalanced financial flows of the past decade. We argue that asset price movements, including the bubbles in equity markets and residential real estate markets, do a better job of explaining the international financial flows. During the period of inflated asset values, U.S. consumers spent their new wealth, with a marginal propensity to consume of about 4%. Our calibrated model predicts the consumption patterns that occurred in the developed economies, specifically the selective consumption booms that arose in the countries that experienced asset bubbles. Our calibrated model also explains why the capital imports were consumed and not invested.

Finally, we show empirically that asset price movements explain a substantial share of the cross-sectional variation in international financial flows. In a sample of 18 OECD countries plus China, we .nd that movements in residential home prices alone explain around 50% of the variation in accumulated current account deficits.

What it doesn’t answer?

In the last section of the paper, we emphasise two open questions. First, our model does not explain why the asset price bubbles occurred in the first place. Second, our model does not explain why interest rates fell between 2000 and 2003.

We argue that the fall in real interest rates can probably be traced to five factors: (1) a shift from equities to fixed income instruments during and after the bursting of the tech bubble, also accompanied by an enormous increase in fixed-income foreign reserves (e.g., Chinese investments in Treasuries); (2) expansionary monetary policy during and after the 2001 recession; (3) the asset shift from Asia to the developed world studied by CFG (2008a and 2008b); (4) a misperception that the world economy had become less risky (.the great moderation.); and (5) misperceptions about the riskiness of non-governmental debt, due partially to the expansion of structured finance and the blessings of the rating agencies. Finally, we emphasise that a global savings glut probably does not explain the fall in interest rates, since the period of falling interest rates coincided with a falling global savings rate.

Hmm.. Actually IMF (and Raghu Rajan in his speech) said this in 2005 WEO. However, IMF said savings have picked up but investments have not. Rajan says in a 2006 speech:

Good afternoon. Even while the Dow Jones Industrial Average has scaled new heights recently, the 10 year Treasury bond is yielding substantially less than the Fed Funds rate, a phenomenon typically associated with recessions. The yield spread in the Euro area also briefly turned negative, even while Europe is enjoying strong growth. Are the markets seriously out of kilter?

I think not, and my argument will rely on three global ingredients. The first is a widespread surge in productivity across the world, with the associated impact on domestic demand varying country by country based on the strength of domestic financial markets. The second is a high desired savings rate that continues unabated, particularly supported by corporations, but also by emerging market governments. The third, and perhaps least well understood, is global investment in physical assets that has yet to return to past levels despite the higher productivity and available savings. Taken together, these forces have resulted both in large global imbalances but also in the benign conditions needed to finance them. Which of these will give, how, and what the consequences will be is a matter of both great import, and unfortunately, one where we have little guidance from the past.

However in the above paper, authors argue savings rate also did not pick up. Interesting and complicated. More research needed.

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2 Responses to “A behavioral perspective to causes of global imbalances”

  1. A behavioral perspective to causes of global imbalances « Mostly … Says:

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